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According to finance theory

corporate finance theory and practice ppt and agency theory in financial management
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Finance Theory II (Corporate Finance) Katharina Lewellen February 5, 2003 1ƒƒ Introduction Corporate finance Investment policy How the firm spends its money (real and financial assets) Financing and payout policy How the firm obtains funds (debt, equity) and disposes of excess cash 4Balance sheet view of the firm Assets Liabilities Current Liabilities Current Assets Long-term debt Fixed Assets 1. Tangible Shareholders’ 2. Intangible Equity 5¾¾¾ ƒƒ Introduction, cont. But we also need to understand… Capital markets Types of securities (stocks, bonds, options…) Trade-off between risk and return Pricing Taxes and government regulation 6Financial markets Financial Markets Firms Curr Debt assets Individuals Fixed Equity assets Financial Intermediaries Government 7ƒƒƒƒƒ Introduction, cont. Finance is really about value Firms Projects and real investments Securities Common characteristic Invest cash today in exchange for cash (hopefully) in the future Central question How do we create value through investment and financing decisions? 8¾¾¾ ƒ Types of questions Investment and financing decisions At the end of 1999, GM had 11.4 billion in cash. Should it invest in new projects or return the cash to shareholders? If it decides to return the cash, should it declare a dividend or repurchase stock? If it decides to invest, what is the most valuable investment? What are the risks? 9¾¾¾¾¾¾ ƒƒƒ General Dynamic Major contractor in the defense industry Doing well during 1980s (cold war) Growth in sales Reasonable profitability R&D and capital investment Beginning of 1990s The end of cold war Likely decline in defense spending Strategy??? 10General Dynamics 1,000 800 Net Inc 600 R&D + Cap Exp 400 200 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 -200 -400 -600 11Value of 100 invested in Jan. ‘80 500 Market 400 300 200 GD 100 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 12General Dynamics Investment, 1980 – 1990 R&D + Capital expenditures: 3.7 billion If invested at 10%: 5.5 billion Ending market value: 1.0 billion Value destroyed: 4.5 billion Sales grew from 4.7 billion to 10.2 billion Earnings in 1990 = -578 million 13¾¾ ƒƒƒƒ New strategy in 1991 William A. Anders (new CEO): Cuts capital expenditure and R&D Cap. Exp. drops from 321 million in 1990 to 81 million in 1991 Sells off divisions and subsidiaries Cuts workforce Distributes cash to shareholders From 1991 through 1993, GD returns 3.4 billion to shareholders and debtholders 14General Dynamics: 1987 – 1997 1,000 CapEx + R&D 800 600 400 200 0 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 -200 -400 Net Inc -600 15Value of 100 invested Jan. ‘91 700 600 GD 500 400 Market 300 200 100 0 1987 1988 1989 1990 1991 1992 1993 1994 16¾¾¾¾ ƒ Types of questions Investment and financing decisions Your firm needs to raise capital to finance growth. Should you issue debt or equity or obtain a bank loan? How will the stock market react to your decision? If you choose debt, should the bonds be convertible? callable? Long or short maturity? If you choose equity, what are the trade-offs between common and preferred stock? 17ƒƒ Types of questions, cont. Investment and financing decisions IBM recently announced that it would repurchase 2.5 billion in stock. Its price jumped 7% after the announcement. Why? How would the market have reacted if IBM increased dividends instead? Suppose Intel made the same announcement. Would we expect the same price response? Motorola wants to build a new chip factory in Ireland. How will fluctuations in the foreign exchange rate affect the value of the project? What are the risks? What actions can Motorola take to hedge the risks? More importantly, should it hedge the risks? What are the costs and benefits? 18ƒƒƒ ¾¾¾¾ ƒƒ Our Approach What we won’t do What we will do Acquire a set of general tools Pretend to be experts in any that are crucial to sound industry, financial or other business decision Financial managers Discuss many institutional General managers aspects in detail Apply and confront them to Discuss in detail stuff you a number of real business could learn just as well cases reading a book or an article Usefulness (see “readings”) Limitations 19ƒƒƒ Outline: Theory + Applications Part I: Financing − Capital structure − Payout policy Part II: Valuation − Project valuation (FCF, PV, Real Options) − Company valuation (M&A, Start-ups) Part III: Selected topics in corporate finance − Corporate governance − Hedging/Risk management 20ƒƒƒƒƒƒƒ The tools of finance (15.401) Time Value of Money Portfolio Theory Asset Pricing Theory Efficient Markets Hypothesis Option Pricing Theory The Concept of No-Arbitrage Agency Theory (Micro-economics, Incentives and Contracts) 21¾¾¾ ƒƒƒƒ Course Requirements Class Participation (10%) Case Memoranda (30%) Teams up to four people Hand in all write-ups except two write-ups of your choice A professional memo to the decision maker Midterm (30%) Final (30%) 22